US Dollar Rebounds as Dow Cracks 14,000
The first trading day in the fourth quarter has kicked off with a bang. The Dow soared to a new all-time high above 14,000 taking carry trades and other high yielding currencies up with it. For most people, the rally in stocks suggests that the worst is behind us, but that sentiment is not exactly an accurate reflection of the problems that the US economy still faces. This morning, Citicorp and UBS both reported a sharp drop in earnings while the sole piece of US economic data released today fell short of expectations. The improvements in the Chicago and Philadelphia Fed manufacturing sectors made the disappointment a very big surprise especially since the prices paid component also dropped from 63 to 59. This indicates that inflationary pressures remain modest, giving the Fed the flexibility to lower interest rates. Therefore the rally in the Dow reflects the stock market’s belief that the Federal Reserve will continue easing monetary policy with the odds of a 50bp rate cut at the end of this month growing. So then why is the US dollar rallying as well? We have actually not seen broad based dollar gains. In fact, the dollar is weaker against the Australian, New Zealand and Canadian dollars. The only currencies that it is stronger against are the Euro, British Pound, Swiss Franc and Japanese Yen. From both a fundamental and technical perspective, this is a corrective rebound and not a turn in trend. There is talk that foreigners have begun to liquidate out of US equities. This could have been due to the quarter end, but with the Dow at a new record, profit taking would not be out of the ordinary. The focus tomorrow will be on pending home sales which are expected to drop once again. There is risk of a rebound given the prior month’s sharp decline, but overall, the housing market is still weak.

Euro: Maybe Trichet Will Wince at Earnings
Despite weakening economic data ECB President Trichet has not changed his monetary policy stance or expressed any concern about the level of the Euro. Instead in his speech this weekend, he simply credited the central bank for its decisive and active response to the recent market turmoil. Now that earning season is beginning however, the central bank head may not have any choice but to recognize the damage that the Euro is having on corporate profitability. Last week, European Aeronautic Defense and Space Company said they stand to lose EUR 1 billion for each 10 cent drop in the US dollar against the Euro, and we are sure that they are not the only ones feeling the pain. Over the past few years, European companies have become more adept at hedging currency risk, but most of these companies probably did not expect the Euro to break 1.40 and head towards 1.50. We expect many companies will be blaming their losses on exchange rate fluctuations. In terms of economic data, even though Eurozone manufacturing PMI remained unchanged, activity slowed in both France and Germany. Switzerland has been experiencing a more material slowdown even though the central bank remains optimistic. Despite a weakening currency, the country has been hit hard by the global financial turmoil. Swiss consumer prices are due for release tomorrow. The falling value of the Franc should boost inflationary pressures.

Australian Dollar Climbs to New 18-Year High, Canadian Dollar at a 31-Year High
Anyone long Australian, New Zealand or Canadian dollars over the past month is being rewarded handsomely as these commodity currencies continue to hit significant highs against the US dollar. Less than six months ago, many traders could not fathom seeing USD/CAD below parity. Now, it is time to think about whether the Australian dollar will also hit parity against the US dollar. There was no economic data released out of any of the three countries overnight. Instead, the rally was fueled by the continual rise in commodity prices. Gold prices hit a 28-year high while platinum prices rose to an all-time high. Oil prices dropped, but remain above $80 a barrel. Unless commodity prices reverse significantly, there is nothing to stop these pairs from moving higher.

British Pound Pares Gains after Sharp Rise on Friday
After coming within 5 pips of 2.05 at the onset of the European trading session, the British pound reversed course to end the day lower against the US dollar. Economic data was slightly weaker than expected with consumer credit, mortgage approvals and manufacturing PMI easing. Like companies in the Eurozone, companies in the UK are also being hurt by the recent strength of the British pound. Last Friday, Tate and Lyle PLC warned that earnings could be weak over the next six months as a direct result of the dollar’s weakness against the British pound. If economic data continues to surprise to the downside this week, expectations for a surprise rate cut on Thursday will grow. Prime Minister Brown said this morning that they will take no risks with the economy. After harsh criticism last month on his response to the Northern Rock problems, Bank of England King probably feels the same way.

Carry Trades Shrug Off Stronger Japanese Economic Data
Carry trades have performed extremely well today thanks to the sharp rise in US equities. Whether the rally continues will be dependent upon how much further the Dow can rise. Although it can be said that risk appetite is back, for many people the rise may still seem too good to be true. For this reason, we could see further gains as the market completely shrugs off stronger Japanese economic data. The market was looking for the Quarterly Tankan report to decline but instead it remained unchanged at 23. Labor cash earnings also rose for the first time in nine months. Unfortunately the BoJ can not do anything about this, given the continual drop in consumer prices.

Kathy Lien is the Chief Currency Strategist at FXCM.